Seeking Alpha

What GOFO Is And Why It's Now Very Bullish For Gold

Includes: GLD, IAU, PHYS
by: Dave Kranzler

This (the price correction in gold) is good news. Gold is doing what it should do. And it is giving us another good opportunity to buy a life vest before the boat sinks. - Bill Bonner, The Daily Reckoning

The Gold Forward Offered Rate (GOFO) is the rate that is used for gold/U.S. dollar swap transactions. That is, if you own gold and you need to borrow dollars, you can use your gold as collateral and pay a much smaller rate of interest to borrow the cash than otherwise. This is a common transaction in London and the GOFO rate is published daily by the LBMA (London Bullion Marketing Association): LBMA GOFO rates.

Under normal market conditions, the GOFO rate is always in a state of contango - i.e. the GOFO rate curve is positive-sloping and rises with the duration of the gold/$swap. However, on rare occasions, the GOFO rate goes negative, which indicates that someone is willing pay interest in order to borrow gold, using dollars as collateral. In fact, a negative GOFO rate means that a higher value is being placed by the market on gold in hand vs. dollars in hand. The negative GOFO is also more evidence that we have likely seen the bottom in this gold correction.

In a very rare occurrence, the GOFO rate went negative out to three months yesterday (see GOFO link above). It went even more negative today. The previous time it went negative was November 20th and 21st, 2008 - but only out to one month. Before that, it went negative out to a year on September 29, 1999, for two days.

The only reason a negative GOFO would occur is if someone desperately needs to get their hands on gold but thinks they'll be able to return it within the time frame of the loan. A negative rate out to three months tells us that there's a big delivery shortage and bullion banks or large investment funds are willing to pay an interest rate to borrow gold and put up dollars as collateral. It also tells us that gold today is worth more than gold re-delivered out to three months.

We have been hearing countless reports of a big shortage of deliverable gold into Asian markets, specifically Hong Kong and Shanghai, as well as Turkey and Dubai. Evidence is the unusually high premiums to the spot price being paid in those markets. In fact, the Emirates NBD - the largest banking group in the Middle East - issued this comment yesterday:

The physical side of the gold market looks strong, with shortages and rising premiums very much visible. The professional physical trading community in Dubai is looking to secure quicker, more immediate available supplies in order to satisfy the strongly growing order books. A significant amount of gold in form of large 12.5 kilo bars is being shipped from gold accounts held in Zurich and London, in order to get re-melted and re-casted into Dubai Good Delivery (DGD) 1 kilo bars. However, a lot of flights are already fully booked for valuables and delays are appearing to become more common. The premium achievable for immediate same day delivery of kilo bars in Dubai has risen from US $ 2 to US $ 3.50 per troy ounce.

The fact that the GOFO rate went negative indicates the severity of the situation and the desperation of those bullion banks and hedge funds who are short Comex futures and LBMA forwards to get a hold of gold bars to deliver into the rightful buyers. It means that the physical shortage of gold we have been reading about is without a doubt very real.

The two previous times in the last 14 years that the GOFO went negative, it happened to correspond with significant market bottoms:

In 2008, the negative GOFO rate appeared almost exactly at the bottom of the 2008 gold correction. On 10/24/2008, gold bottomed at $6.81 and closed that day at $729). Gold then commenced on a three-year move up to $1,900.

In 1999, the extreme negative GOFO rate coincided almost exactly with the bottom of the 20-year bear market in gold. On 9/16/1999, gold closed at $256. Ten days later the GOFO went very negative for two days. Just prior to the price bottom and the negative GOFO occurrence, the UK Chancellor of the Exchequer - Gordon Brown - infamously announced the sale of 50% of the Bank of England's gold (400 tonnes). Clearly he was alarmed by the shortage of physical gold. It alleviated the negative GOFO, but it also marked the bottom of the bear market in gold.

With this in mind, I would offer that the current negative GOFO will also coincide with the bottom of the current nasty correction in precious metals. I have been writing about gold being at a bottom for the past couple of months based on signals that have worked well over the past 12 years. In my previous article discussing this topic, I explain why Friday June 28th, was likely the bottom. The indicators I highlight in that article are even more bullish as of yesterday's COT report. So far the intra-day bottom ($1,179) on that day has held. The negative GOFO is an even stronger signal that a bottom in gold is forming.

If you agree with me that the bottom is in or close to in, the best way to start playing this is to first buy physical gold and silver that you keep in your possession. If you want to speculate on the next move up in gold, the easiest way to express this view is to buy GLD or long term out of the money call options on GLD. The premiums on the calls have been washed out by excessive downside volatility and are cheap relative to the probability that the next move in gold is a lot higher. I would recommend going out at least six months on those. There are some other ways to leverage your returns on the sector that I'll cover in upcoming articles.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long physical gold and silver as is the fund I manage.